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Guest post: Bitcoin, Money and Free Banking (by Lasse Birk Olesen)

Lee Kelly in a recent guest post here on The Market Monetarist discussed the implication of excess demand for money for the development of barter and Free Banking. I found Lee’s discussion extremely interesting and think that it could be interesting to see how monetary disequilibrium actually could work as a catalyst for the development of alternative monetary systems – for example the development of so-called local currencies in Greece.

One of the most interesting developments in recently years in the fields of alternative monetary systems is Bitcoin. I am no expect on Bitcoin and I have certainly not made up my mind about the implications of Bitcoin so I have asked the founder of BitcoinNordic.com Lasse Birk Olesen to do a guest post about Bitcoin. I am happy that Lasse has accepted the challenge.

Started in 2009, the decentralized means of exchange for the internet known as Bitcoin has been gaining traction every year since. With no central institution backing it, with no one knowing whether to classify it as currency or as commodity, and their inherent nature making them hard to regulate, Bitcoin has been the subject of much controversy. This post is a short summary of what I have learned about Bitcoin and serves as an introduction to the concept, its economic properties, and a couple of its potential implications for the financial infrastructure of the world.

How does it work? Consider a special type of e-mail that cannot be copied. This means that when you forward this e-mail to someone else, you must lose it from your own inbox. Now also consider that there exists only a finite amount of these special e-mails, and no one can create more of them. Because of these properties, people have started considering these e-mails as valuable. These unique e-mails are of course called Bitcoins.

Value
As Bitcoins have no physical manifestation and no use besides as a medium of exchange, many economists (some citing Mises’ regression theorem) have predicted their value to be a bubble driven by novelty and hype, just waiting for an inevitable burst.

And the Bitcoin price definitely did experience a bubble in the summer of 2011. Going from 1 USD/BTC to 30 USD/BTC in just 2 months from April to June and then dropping back to 2 USD/BTC in November, most of the Bitcoin critics would probably have bet that the show was over. But over the next couple of months the exchange rate went back to 5 USD/BTC and has remained in that area since.

While the exchange rate is not in itself an indicator of the success of Bitcoin, it is of course an indicator of the market’s expectation of the future success of Bitcoin. If Bitcoin enjoys widespread adoption its exchange rate is bound to rise as demand increases.

But while the Bitcoin critics are right that most historical money such as gold had other uses before they became accepted as money, as Mises’ regression theorem states, this does not mean that it is the only way a viable money can come into existence.

Historical examples of money with no other uses exist. One is the case of large rocks known as rai stones which were used for trade between the islands of Micronesia. The rocks, definitely too large for use as tools, derived their value solely from being a means of exchange. In other words, the only reason to value them was because everyone else did.

Properties as money
And so is the case with Bitcoin. With no institution guaranteeing their value, with no guaranteed exchange rate to traditional currencies, Bitcoins’ value stems only from their use as a means of exchange. But unlike the rai stones, which were difficult to transport, Bitcoins ace almost all of the requirements traditionally set forth for good money:

Scarce: No more than 21 million will ever exist

Divisible: Each of the 21 million can be divided infinitely

Fungible: One Bitcoin is as good as the next

Mobile: Can be sent from New York to Tokyo in 10 seconds for an infinitesimal fee

Durable: Will remain intact as long as anyone uses the system

In addition, Bitcoin is the first electronic cash system being completely decentralized and semi-anonymous. No one needs to know who you pay or how many you own. Adding these properties together gives you a unique money system that the world has not seen before. It streamlines many financial operations, and it can open up entirely new markets that had been impossible until now. This uniqueness is what drives the support of the Bitcoin community and gives each coin value. No other system currently allows you to transfer value to the other side of the world in seconds practically for free and without identifying yourself.

As a store of value, however, Bitcoins are still a very poor money, as the mentions of the exchange rate above shows. But with the existence of liquid exchanges to traditional currencies in multiple countries it retains its use as an international transfer of value. And if Bitcoin sees widespread adoption the exchange rate will become less volatile as market depth increases.

Free banking
The inherently decentralized and semi-anonymous nature of Bitcoin makes it hard to regulate. You cannot punish a violator of your country’s laws if you do not know who he is. And you cannot shut down a system if it doesn’t have a point of attack. Trying to close decentralized networks such as Bitcoin is like cutting off Hydra’s heads: Cut one and two new ones grow as the entertainment industry has already realized in combating file sharing networks.

This means that Bitcoin will potentially enable free banking in Bitcoins even if government regulation doesn’t allow it as banks can keep accounts and transactions hidden.

At the moment, there is little to no banking activity in the Bitcoin economy. Lending is done on a peer-to-peer basis between forum users across the world. Because of the difficulty in assigning credit ratings to internet nicknames, interest rates are naturally high in this very interesting and unregulated developing market.

If Bitcoin adoption grows, we should expect actual banks, with or without government banking licenses, to appear to judge borrowers based on face to face interactions instead of internet forum posts.

A common misconception is that fractional reserve banking is impossible with Bitcoins. But just as fractional reserve banking can be done with gold it can be done with Bitcoins.

Less banking
In addition to new opportunities for free banking, I predict that given a larger adoption of Bitcoin we will also see less private banking. The main reason most people store fiat money in banks is not to get interest on their small amount of savings. They do it to for security and to be able to participate in the electronic economy – that is, to be able to shop online and avoid the need to carry around cash and use credit cards instead.

Bitcoins are incredibly flexible when it comes to storage. They can be stored on any digital or analog medium, encrypted by cryptography stronger than used in online banking, and backed up to an infinite amount of locations. They can even be saved in your brain. If your assets are in Bitcoin you no longer need a bank for safeguarding.

And as they are inherently digital, you don’t need a bank to act as a gateway for you to spend them in the electronic economy. Stored on your smartphone you could carry them to a restaurant and pay the bill using your phone instead of a card.

People having less reasons to store their money in banks will contribute to a higher real interest rate. On the other hand, the deflationary nature of Bitcoin will encourage savings and contribute to a lower interest rate. I cannot predict which will be the dominating effect (note: corrected slightly compared to earlier version).

Bitcoin-enforced contracts
An interesting development is the creation of Bitcoin-enforced contracts. For an example of how this could work consider you bought a car for a small down payment and has agreed to make more payments once a month. With the car being connected to the Bitcoin network, it could check for new payments to the seller’s Bitcoin address every month. If your monthly payment has not arrived the car will refuse to start.

One could also imagine this happening today with a deactivation system remote controlled by the car seller. But what if the seller deactivated your car after you had already made all your payments? With a Bitcoin-enforced contract you don’t need to trust the seller, you only need to trust the Bitcoin network of which everyone can check the source code.

Also, scripts can be embedded into Bitcoin transactions which opens up for even more contractual possibilities. One use of this is for pooling resources towards a common good, i.e. to fund the creation of something with positive externalities.

Say your neighborhood wants to buy an empty lot to turn it into a park. Normally someone will start raising money, but what happens if he doesn’t get enough to actually complete the project? Can you trust him to give you your money back? Instead, you can make your donation to his Bitcoin address with the condition that the money is returned to you if not X amount has been sent by others to the same address before Y date. The Bitcoin network will enforce this without you needing to trust the person accepting the donation or even a third party.

The future
As seen in the above section on contracts, Bitcoin is more than a better means of exchange. People discover new uses for the technology every month.

One can conceive of several threats to Bitcoin’s survival and widespread adoption: Could a flaw in the design be discovered that leaves the system open to counterfeiting? It’s very unlikely since it hasn’t been discovered yet even as there is a large financial incentive to do so. And if it happens, the system allows for large structural repairs while carrying on using the same coins. Will the world find no utility in larger adoption of Bitcoin? Unlikely as the financial infrastructure of today belongs to the pre-internet era. For instance, it shouldn’t take days and cost tens of dollars to move value from Europe to the US or Asia.

Perhaps the biggest threat would be from a technically superior Bitcoin 2 that could replace the current system and leave original Bitcoins worthless. As Bitcoin has the momentum, Bitcoin 2 would need to be vastly improved. And as with anything new, the change will not happen in the blink of an eye. Some will be risk takers and make early investments in Bitcoin 2 while others will stick with the good ol’ familiar Bitcoin for a longer time.

I remain optimistic on behalf of Bitcoin. And it certainly is an incredibly exciting experiment that no matter the outcome will have an impact on the theory of money.

32 Comments

Kim Hvid Johnsen

“The inherently decentralized and semi-anonymous nature of Bitcoin makes it hard to regulate. You cannot punish a violator of your country’s laws if you do not know who he is. And you cannot shut down a system if it doesn’t have a point of attack. Trying to close decentralized networks such as Bitcoin is like cutting off Hydra’s heads: Cut one and two new ones grow as the entertainment industry has already realized in combating file sharing networks.”
As an historian I take exception to this point.
I have had this discussion with LBO in person before, and probably will again. I think the Bitcoin people vastly underestimate the State’s interest in control over money. In every succesfull civilization, from China to the European states, the state have had a monopoly on currency. In Europe a monopoly was widespread and by the end of the middle ages exclusive. The modern nation state was build on control of money (not the only factor, but a
Very important one) as has been shown by many historians, sociologists and economists (Tilly, Charles : Coercion, Capital, and European States, AD 900–1990, and Niall Ferguson the ascent of money, and many more). Comparing it to the states interest in pirating of Software and movies is a bad one, it’s like comparing the police combatting bicycle theft and murder. If bitcoins become successfull, they will either become illegal, and be combatted fiercely or it will be somehow assimilated into the existing system. I would describe money as imbedded into the fabric of the modern state, and this knowledge is tacit in every bureaucrat worth their salt.

blademccool

You are right, the modern nation state was built on control of money. And that is why Bitcoin is going to bury the idea of nationalism. People will stop paying their nationstate taxes as they adopt Bitcoin and realize the plausible deniability behind all their transactions. When the states run out of money, they will wither and die. And there is not much they can really do about it. The argument here is that they will try to stop Bitcoin yes, and they will fail spectacularly, and then we’ll be in some kind of post-national era / crypto-anarchy or something, it will be weird, it will work, people will be happy and more free than ever. The world that Bitcoin is going to build will be full of life and love. Bitcoin is the greatest invention since agriculture, and no centralized power can stop it.

Bill Ramsay

Bill Ramsay

“….An interesting development is the creation of Bitcoin-enforced contracts….”

That’s like saying you’ve got a brilliant new idea called a Dollar-enforced contract, that you could use to enforce car payments. What is described could be developed in any currency system.

The essence of the article simply describes the invention called currency. But Bitcoin as described isn’t even a currency. It’s a virtual commodity, with gigantic flaws like having absolutely no use other than as a backing for itself and a hope that an actual currency will develop at sufficient scale to be meaningful.

And that brings up another huge problem, The amount is limited to a quantity that can’t possibly be large enough to scale to any significance. A currency is like a language, if few people use it, it doesn’t make it more valuable, it makes it less valuable.

This statement is hilarious “….In a world of universal Bitcoin adoption with less private deposits in banks coupled with the deflationary nature of Bitcoin, it seems likely that real interest rates will be higher than today.” He does get the first part right, that a currency that is based off a finite commodity would be massively deflationary, but high interest rates are impossible if you truly keep the currency limited because high interest rates require and/or are caused by more currency, else you get tons of defaults. Hmmm, I guess that is possible and it looks like the Great Depression.

So with it’s lack of any real innovation, the author makes an obvious appeal to tax cheats- “No one needs to know who you pay or how many you own.” That is disgusting.

There have been some semi successful alternative local currencies, but they all ultimately fail. Europe has had one for decades, but it had to be massively devalued I think in the 70’s, and will always be devaluing in the black market.

They all go through the same evolution. There is excitement to begin with, though the most enthusiastic adopters are struggling financially. A few businesses adopt it, some are struggling, some get caught up in the excitement, some think it makes for good community PR, and some feel they have to. Ultimately, the participating businesses with the most valuable products or services get stuck with a pile of the alternative notes, because there has been poor pricing (many of them are labor time based- everyone’s time is worth the same), poor accounting and a fundamental failure to address what all currencies face- the fact that some people will not honor their commitments, either because of excess optimism about what they’ll be able to do in the future, simple misfortune or blatant cheating.

They can have a limited lifespan in situations where there is a scarcity of widely accepted Central Bank backed currency, but I don’t think any will last. And in the circumstances where there is currency scarcity, the solutions are typically some combination of simply “printing” more money, debt defaults or inflation to reduce the debt burden. In other words, the way the world works.

Kim: There definitely are historical examples of free banking with banks backing their notes by commodities. I don’t see any technical measures that can be taken to stop Bitcoin short of shutting down the internet. The companies that currently exchange traditional currency for Bitcoins are points of attack of the infrastructure, but even with those gone people would be able to exchange in a peer to peer fashion. This would slow the adoption, but I don’t think it would stop it.

And it’s entirely possible that Bitcoin will not grow in our parts of the world but will see adoption in developing countries that are willing to try an alternative to their failed monetary policies.

Bill Ramsay: The difference between dollar-enforced contracts and Bitcoin-enforced contracts is that you remove some of the need for trust. For instance my example with pooling ressources for building a park. It may be less of an issue when you know your neighbors, but when crowdfunding projects across the globe, a model that’s definitely growing, you need to trust a third party with your money. This is not needed with scripted Bitcoin transactions and could strengthen this financing model.

“gigantic flaws like having absolutely no use other than as a backing for itself”

Indeed, Bitcoin would be easier to trust with some kind of backing. But it doesn’t seem enough to rule it out because means of exchange have existed before that didn’t have any backing. I gave you one example in the article with the rai stones, another example would be the Iraqi Swiss Dinar: http://en.wikipedia.org/wiki/Iraqi_Swiss_dinar

“The amount is limited to a quantity that can’t possibly be large enough to scale to any significance.”

I don’t think you’ve given my post enough attention. While the quantity of the units called “Bitcoins” are indeed only 21 million, each of these units can be divided infinitely. So, one could just as well say there exists 21,000,000,000,000 microBitcoins. If that’s not enough either you can use another prefix.

“high interest rates are impossible if you truly keep the currency limited because high interest rates require and/or are caused by more currency”

You’re right, deflation would encourage savings and lower interest rates. A slip of the mind on my part, sorry. So we have deflation contributing to a lower interest rate, while we have people with less incentive coming from security and usability to store their savings in banks contributing to a higher interest rate. I cannot predict which one will have the dominating effect.

rjaklic

Bill Ramsay

“I think the Bitcoin people vastly underestimate the State’s interest in control over money. In every succesfull civilization, from China to the European states, the state have had a monopoly on currency. ”

The first sentence seems to imply nefariousness. But the I think that the second sentence would probably be more accurate if restated to something like “Successful large scale societies appear to require the state to have a monopoly on currency.”

Of course there are examples of states abusing that power or being bad at monetary policy, but states are the only entities that can establish sufficient faith in a currency for a large scale society to be successful.

Lasse siad

“So, one could just as well say there exists 21,000,000,000,000 microBitcoins.”

That is exactly my point about Bitcoin being a virtual commodity and hoping that an actual currency will develop that uses Bitcoin as the backing.

Fundamentally, with a fiat currency regime under state monopoly control, the backing isn’t some arbitrary commodity like Bitcoins (or gold), it is mostly the productive capacity of the nation (and perhaps its military might, depending on the level of global civility). If too much money is created, it devalues and infation follows (1970s). If too little is created, deflation ensues and productive capacity decreases to match the level of currency (1930s).

In many cases, the private sector actually drives the amount of money creation, with the central bank merely supporting the amount created by private sector.

rjaklic

Perhaps I overstated. There may be an actual innovation- but it is not the innovation of currency. If there is, it is the digital storage method and even there I’m not sure it’s really different than an accounting mechanism like banks use today. However even if that is a real invention, as Kim said “…..it will be somehow assimilated into the existing system.”

Kim Hvid Johnsen

A state is not nefarious nor virtuous which is the opposite. Such words have no meaning when discussing the state as an historical entity. Now if we look at concrete examples such words occasionally make sense. I actually don’t think the succes of modern society is based on the states monopoly on money. What I meant to say was that the states that survived the great reduction in the number of state like enteties, that happened from the middle ages to about ww2, did so because they had an efficient control of money (among other things). That control was an essential component in the competition between states, as it allowed for better financing of wars.

Bill Ramsay

I don’t think its just about financing of wars, I’d suggest that a strong state managed currency allows for greater capital formation and thus more rapid technological development and economies of scale.

(1) Since the cost of security and access to the ‘electronic economy’ would be significantly less under Bitcoin, banks would attract depositors on alternate margins. For example, interest rates offered on deposits could be notably higher at a Bitcoin bank or other hitherto unimagined services may be offered. In other words, there are multiple margins that banks can operate on to attract depositors, so I see little reason to suppose that there would be less banking in a Bitcoin world. Indeed, if it were true, then this would be a major weakness of the system, because …

(2) The supply of Bitcoins is only tenuously related to the demand for Bitcoins. At the moment, this is not such a big problem, because Bitcoin is not the generally accepted medium of exchange. The market for Bitcoins clears mostly by changes in its exchange rate (i.e. it’s price in terms of US Dollars) with only a small and eclectic mix of goods that are affected by monetary disequilibria. This wold stop being true in a world where Bitcoin was a major player, where goods and services, accounts and transactions were routinely denominated and settled in Bitcoins. In that world, Bitcoin would make for a fragile economy. The best solution to this is …

(3) Fractional reserve banking, yay! In other words, we’re back to point number 1: Bitcoin will not succeed (except as a minor alternative to money, particularly in situations where official monies are being horribly mismanaged) if it deters banking.

The underlying problem is that Bitcoin’s creators appeared to be working with a gold-is-money view. Gold may be very good money, but it doesn’t follow that good money is always like gold.

Robert

Great thing about bitcoin is, that it will evolve by itself. Noone can manipulate money supply, noone can regulate it. It’s up to people and free market to decide wheather bitcoin as a money system will succeed and in which types of uses.

Of course it CAN be used to pay anything… the point is that if you so choose not to pay, there is no bank account to seize. The State cannot take your Bitcoins unless it finds you, grabs you, and tortures you into divulging the locations and passwords. I wouldn’t put that past the thugs.

Bill Ramsay

A system where everyone gets to decide whether and how much tax they are going to pay. Wow, why hasn’t anyone thought of that before! I’m sure that will lead to the most perfectest society the universe has ever seen! I’m sure everyone can agree on what’s fair.

BTW Erik, FeedZeBirds looks like a business, so I hope you are choosing to pay taxes since it doesn’t matter if you are conducting it in bitcoins, it is still taxable, and in this country choosing not to pay taxes is illegal. And you are also subject to the rules governing the issuance of 1099’s to anyone that you pay more than $600 equivalent in a year for retweeting services.

Lasse and other bitcoin promoters, I hope you will also inform your bitcoin users that at least in the US, the tax laws still apply. The following is clearly not only false but actively encouraging stealing from taxpayers.

Of course I’m sure conspiracy lovers will read this and decide that enforcing tax laws on bitcoins would be an attempt by governments to destroy bitcoins. But for me and the rest of the honest taxpayers, better enforcement of tax laws means lower taxes.

Mike

Of course it can be used to pay taxes, but only if the owner of the bitcoins chooses too. The state cannot indirectly force holders of bitcoins through coercion of law to pay their taxes. Basically, it will strengthen a republic form of government where the individual is at the top of the food chain and not government. Government becomes the servant like it should be and not the other way around.

John 'Blue' Doe

“Could a flaw in the design be discovered that leaves the system open to counterfeiting? It’s very unlikely since it hasn’t been discovered yet even as there is a large financial incentive to do so. And if it happens, the system allows for large structural repairs while carrying on using the same coins.”
Bitcoins are technically “blocks”. Blocks are created statistically every 10 minutes and the first 210 000 blocks have a value of 50 bitcoins each. The next 210 000 blocks(we’re not there yet!) will have a value of half, rounded down if there are decimals(25 bitcoins).
Still with me?
The next will have half until one sunny day a block will have a value of 0 bitcoins.

What does this have to do with counterfeiting?
When a block is created it was created by doing something very difficult. Each block is roughly a number that is sought randomly, that if shown in hexadecimal it will have a certain number of zeroes example: 00000000000005c35a2ce25dc1fa300a74848ee506785672022abaf147ded958.
See? Now, if you want to create a Bitcoin you’ll have to calculate a number(that is also based on the previous block’s number) that will create a new number that is with a certain amount of zeroes just as in the above example. You search randomly because luck is your primary “weapon”. Let’s say the I also search for the number so I can get the block for myself.
Surprise! –> We are not searching for the same number.
If I want to get the amount of bitcoins that the block equals then I have to put my “bitcoin account”(which is a Public Key, cryptography stuff mates!) which the number I calculate is based on. So I search for a number that is different than your number. So you trying to ‘steal’ my number…it won’t work. Or you will just succeed in sending the Bitcoins to me.

Right, but what does this have to do with counterfeiting, (asking twice)?
It got answered above, although in a rather clumsy manner. If anyone wants to “counterfeit” Bitcoins, like creating a block that is not based on any previous blocks in Bitcoin, it cannot be accepted by the network. Example my Bitcoin client will find that your block is not valid because it isn’t based on any of the previous existing blocks.

That should explain some stuff, but I’m willing to explain more or continue because what I have written is almost like an essay, sort of.

Ron Ronson

This is a very interesting concept and I see no inherent reason why this kind of currency could not reach the same levels of marketability as govt-sponsored fiat currencies.

However in its current form this currency seems poorly suited for one of the key functions of money – economic calculation (deciding if a particular activity is profitable or not). The reason for this is that the way the currency is set up is that supply is independent from demand. If the number of transactions increases faster than the supply of money or if the demand to hold the currency increases then prices will have to fall. If there is too much volatility in the demand for the currency then prices will fail to adjust fast enough to reflect real relative values. Business will be deterred from using the new currency as a unit of account and the currency will never be more than a tool for anonymous internet transactions.

Has anyone considered a currency like Bitcoin but where supply rather than being fixed in advance would automatically adjust to demand and allow prices to accurately reflect underlying values ? A simple way that this could be done would be to peg the currency to a basket of commodities and expand or contract the supply of currency to maintain the value over time (I’m sure more sophisticated algorithms for this would also be possible). The size of the money supply could be adjusted via a “subsidy” (to expand ) or a “tax”(to decrease) on transactions (the “taxes” would just disappear from circulation). This would allow the currency to expand at the correct rate as the market for it grew and to adjust for changes in demand due to confidence factors.

A currency with these attributes would be ideal for economic calculations and allow it to seriously compete with state-funded monies and contribute to economic,stability.

Well, the states have accomplished a few things along the way, so yes, I would prefer that democratic states that actually protect rights survive. I will concede that is a minority of states.

However, having Genghis Khan pour into town, rape all the women and seize all goods, and sell me into slavery is not an appealing option either.

My commit on bit coin is this: You can’t pay taxes with it, so its value is only what other people say it is. Fiat currency has value to pay taxes, so it will always have value to the public. If I accept a $20 bill from you, I know I can pay taxes with it, so it has some value.

Bitcoin is interesting to me in this regard: If people accept it, it amounts to an increase in the money supply (which we need, btw). It buttresses what i always have said: There are times when increasing the money supply results in increases in output. If people shine your shows for 5 bitcoins, then wealth and income is created, and if the shoeshine man can buy chocolate bars then he benefits etc etc act as the bitcoin circulates around.

It is like introducing a counterfeit but passable $10 bill in the Old West—everyone trades the bill around boosting real wealth and income. This is ho much of our American West was in fact developed.

Gold nuts genuflect to the wrong monetary Gods, as these examples show.

josh

It’s not completely anonymous. Correct me if I’m wrong but if we do business in bitcoin the I have to give you my bitcoin address. If there’s enough money in play then that can lead to investigations and legal problems, right?

The gov could just confiscate my property other than bitcoin (house, cars).